Beware the Hobby Loss Rule: A Potentially Very Costly Mistake for Taxpayers

If the IRS thinks you have a hobby instead of a business, it could cost you a lot in taxes.

If the money you spend on your business exceeds your business income for the year, your business incurs a loss. There is a bright side: You can use a business loss to offset other income you may have—for example, interest income, or you can accumulate your losses and apply them to reduce your income taxes in future or past years.

However, if you keep incurring losses year after year, you need to be very concerned about running afoul of what is known as the “hobby loss rule.” This rule could cost you a fortune in additional income taxes. The IRS created the hobby loss rule to prevent taxpayers from entering into ventures primarily to incur expenses they could deduct from their other incomes. If the IRS views what you do as a hobby, there will be severe limits on what expenses you can deduct.

A venture is a business if you engage in it to make a profit. You don't have to earn a profit every year, however. Indeed, the IRS will presume your venture is a business if you earn a profit in three out of five consecutive years.

If you keep incurring losses and can’t satisfy the profit test, you by no means have to throw in the towel and treat your venture as a hobby. You can continue to treat it as a business and fully deduct your losses. However, you must be prepared to convince the IRS that your business is not a hobby in case you’re audited--and there is a good chance you will be audited.

People who have lost money for many years in a row have been able to convince the IRS or courts that they were in business. In one recent case, for example, the tax court ruled that a taxpayer's track coaching venture, which had losses for eight straight years and a profit of $43 in the ninth year, was a business for tax purposes. (Parks v. Comm'r, T.C. Summary 2012-105 (10/25/12).)

That's a lot of losses. How did the coach win his case? He showed that he was serious about earning a profit by carrying on his coaching venture in a business-like manner:

He kept receipts and religiously entered his income and expenses into a computerized recordkeeping system.

He sought professional help from an expert coach, who advised him on how to run a more successful and profitable coaching business. By following this advice, the taxpayer began coaching more athletes with higher potential, including one with a worldwide reputation.

He had substantial expertize to coach track.

He spent substantial time on his coaching activity--indeed, he spent so much time on it that it negatively affected his marriage.

The moral: you don't necessarily have to ruin your marriage to show that you're in business, but it might help show you were serious about trying to make a profit.